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Building a Better Hedge Fund​Using Cognitive Science to Advance the Business of Alpha Generation

﻿After nearly thirty years in investment management, I’ve witnessed the best and worst this industry has to offer. Almost since day one, I have been afforded the great opportunity to take risk, to experiment with styles, instruments and methodologies, so that I may learn from my inevitable mistakes, as well as the occasional successes. Every step of the way, whether I was an advisor at Drexel Burnham, an exotics trader at Credit Suisse, head of currency options at Bank of America, running emerging markets at AIG International or directing a billion dollar hedge fund, the goal has always been to learn and improve. This paper is the result of the many lessons learned with heavy influence derived from studying and teaching cognitive science for almost 25 years.

What follows are simple adjustments that any firm can implement, but because much of it represents a fundamentally different approach to what has been considered standard operating procedure for decades, some aspects are likely to face great pushback. (I know this from first hand experience.) Ultimately, the goal of each and every facet is to create a business that maximizes the potential of its talent, and capitalize on it.

Rather than fighting natural tendencies, the idea here is to use them as a force for good. It’s based on the Taoist principal of yielding to an opponent’s force in order to render it useless. It also shares many of the principles of the libertarian paternalism concept described by Sunstein and Thaler in their book, Nudge. The libertarian aspect "makes it easy for people to go their own way; to not burden those who want to exercise their freedom." Combine this with paternalistic policies which "try to influence choices in a way that will make choosers better off, as judged by themselves," and you create an environment which is a breeding ground for intelligent, independent decision making.

The intention is for the business, and every one of its components, to shift from being reactive to proactive. With the approach described in the following paper, decision makers at every level are bound to the results of their own decisions, making the business a true meritocracy, from top to bottom. By augmenting reactionary risk management techniques such as speed bumps and tight stops with more proactive concepts, style drift and other issues in need of attention can be identified before they become an issue.

It is my hope that this piece will trigger discussion and debate. It certainly did when it was first implemented as, The Experiment.